As Fear Gripped Markets, Even Reliable Mutual Fund Strategies Didn't Work

By Nancy Trejos and Alejandro Lazo
Washington Post Staff Writers
Sunday, October 5, 2008

It's been a rocky year for all investors, but for those who parked their money in mutual funds, it's been downright shocking.

The public's crisis of confidence in the stock market, in the economy and in the country's political leadership pummeled virtually all mutual funds in the third quarter, with 87 percent ending in the red, according to the market research firm Lipper. September was particularly brutal as the government takeover of the mortgage giants Fannie Mae and Freddie Mac, the near failure of the insurance powerhouse AIG, and the very real failure of several large commercial and investment banks further stoked investors' fear that a deep recession was on the way. In just one month, 93 percent of mutual funds lost money, confounding the many investors who rely on them for retirement income.

It didn't matter if the funds were invested in big, quality companies or mid-size ones, in domestic stocks or global ones, in utilities or commodities, in stocks or bonds. Most every mutual fund category got hit.

"The quarter could be defined more so as a quarter gripped with fear, and I think all the diversification strategies, all the asset-allocation strategies that tend to work in a rational market basically didn't work," said Bob Froehlich, vice chairman of DWS Investments in New York.

Even those funds considered most safe -- money-market mutual funds -- nearly imploded this quarter when a major fund announced that it was devaluing shares after the value of its investments dropped. In a period of seven days, investors pulled out a record $169 billion from money markets, and the federal government agreed to insure the funds for a limited time.

"There was nowhere to hide," said Adam Bold, founder of the Mutual Fund Store, an asset management firm in Overland Park, Kan. "Stocks were down, bonds were down, commodities were down. There was nowhere to go."

So investors went to the next-safest places they could think of -- U.S. Treasury bills and cash. What was notable about the third quarter, and September in particular, was that investors fled both stocks and bonds to seek shelter, said Conrad Gann, president and chief operating officer of TrimTabs Investment Research, which tracks the flow of money in and out of mutual funds.

"Because of the credit problems, they are worried about defaults on bonds. Everybody is going to the safest forms of cash they can find," Gann said. "People are scared; they don't want risky investments. There is risk aversion . . . in all of its forms, credit or equity."

Money has been pouring out of mutual funds all year. In the third quarter alone, investors pulled $89.3 billion out of global and U.S. mutual funds and $19.1 billion out of mutual funds that invest in bonds, according to preliminary data from TrimTabs.

There is still much uncertainty as investors enter the final quarter. Whether there is a recovery depends in large part on how a federal bailout plan is implemented. If the bailout succeeds, it could ease the credit crunch that has toppled so many financial institutions and diminished the wealth of not just those who had a lot but of those who had a little. That could calm investors and restore stability to the stock market.

Investors are also keeping a close watch on the Federal Reserve's moves. Will the Fed cut interest rates, and if it does, will the European Central Bank and the Bank of England follow suit? The other cliffhanger bringing unease to the markets is the presidential election.

"Right now, with the uncertainty of the election, the bailout plan, there's just people so unsure of what's going to happen," said Wendell Perkins, chief investment officer of Optique Capital Management in Milwaukee. "Once we can get through the November election and we have a clear and decisive winner -- I don't think it matters who it is -- I think that will go a long way."

What is an investor to do when there is no way to tell if recovery or recession is on the horizon?

Now is a time for diligence, investment strategists said.

"Sometimes when the market does too well, we don't do our homework," Froehlich said.

Don't let the name of a mutual fund deceive you, he said. A fund could have the word "infrastructure" in it, for instance, but behave more like a utilities fund. Understand the sectors your fund invested in. You should know whether your money is in a science-and-technology fund, a financial services fund or a utilities fund. Read about the fund's top 10 holdings.

Researching mutual funds is not that hard. Their Web sites often have a trove of information, including lists of their holdings, and you can easily get a copy of a fund's prospectus. Now may be the time to read the prospectus and decide whether the fund's goals align with yours.

"If you can't sleep at night, then that probably means that your investments are too risky," said Axel Merk, chief investment officer of Merk Mutual Funds in Palo Alto, Calif. "Be critical, and ask questions -- ask your broker, 'What is this money-market fund all about?' If you are not satisfied, then take your money out."

But don't go too safe, strategists said.

With the inflation rate as high as it is, cash is only going to depreciate. And even the highest-yielding certificates of deposit are not keeping up with inflation. Short-term Treasury bills, meanwhile, are yielding very little.

"It's never good to do something out of abject fear," said John Coumarianos, mutual fund analyst for the research firm Morningstar. "You're not getting paid anything in Treasurys now."

Keep in mind that most every stock, sector, bond, you name it, has been bruised, and even if your fund is in the negative, it may still be doing better than others, strategists said. "This is a time when we have to look at relative performance as opposed to absolute performance," said Bold, of the Mutual Fund Store.

Still, it's okay to make adjustments to your portfolio. Diversification, as always, is key, strategists said.

"This is not just about stocks and bonds anymore for U.S. investors," Froehlich said. "They need to get exposure into real estate, commodities, infrastructure, the building of roads and airports. They need a broadly diversified portfolio."

But don't bottom-fish, said Charles Zhang, founder and managing partner of Zhang Financial in Portage, Mich. Don't forgo an analysis of a stock's fundamentals just because the price is right. "Be very careful. Don't buy stocks because they're cheap. A lot of people make that mistake," Zhang said.

There were plenty of mistakes in the third quarter, but they weren't necessarily the fault of investors or fund managers.

"What was in favor two quarters ago is now the pariah, and the pariahs of the past are now what is popular," said Tom Roseen, a senior research analyst at Lipper.

Remember when everyone was pushing emerging markets? Those funds were down 27 percent for the quarter. The biggest loser among world equity funds was the Latin American ones. They were down 32.4 percent. The Chinese and Indian economies also slowed. Overall, world equity funds were down 21.02 percent.

"The dollar was weak at the same time credit markets tightened globally. We had a jump in the U.S. dollar, gold prices dropped, oil prices dropped," Roseen said. "We had the U.S. contagion actually roll over to the overseas markets."

Those commodities funds that people were flocking to earlier this year fell out of favor thanks to a drop in oil prices, which posted a 25.6 percent decline for the quarter. Natural resources and global natural resources funds fared worse, with drops of about 33 percent each, because of investors' fear that in a global recession, demand for energy, oil and natural gas would slow.

Most surprising was the lackluster performance of bond funds, typically considered solid investment choices because of their relatively low volatility and steady interest payments. According to Morningstar, all municipal-bond-fund categories were down. "People are losing 30 or 40 percent on an insured municipal bond? That's crazy," Zhang said.

The turmoil in money-market mutual funds was another big blow. Money-market mutual fund assets were down $82 billion for the quarter, said Peter Crane, president and publisher of Crane Data, which tracks the industry. "It's going to be a tough slog regaining the trust of investors," he said. "It took money funds 37 years to build up that record of trust and confidence, and they lost a lot of it in one week."

The quarter did, however, see a modest revival in value funds, which had been trailing growth funds most of the year. Value-fund managers search for stocks that are priced low relative to their earnings potential, which means they were picking up lots of financials, which means they've been whacked pretty hard. Growth-fund managers, on the other hand, pick the fastest-growing companies.

Other funds making comebacks were those with financial services and real estate holdings. Financial services funds edged up 2.49 percent, while real estate funds increased 1.92 percent. Why?

Investors started to recognize those banks that did not get into the troubled loans now dragging down the economy. "What we have is a have and have-not market in the financial services sector," Bold said. "There are a lot of smaller, community banks that never got into subprime mortgages and so their balance sheets look really good."

In times of uncertainty, real estate funds seem attractive to investors because they have tangible assets to hold on to, analysts said. Plus, they've been knocked around so much that there's just not much more they can take. "There really wasn't any more blood to take out of it," Bold said.

And that, perhaps, is what investors hope will save mutual funds -- and the stock market in general -- this next quarter.

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